The Importance of the U.S. Dollar

To trade the currency markets implies buying or selling different currency pairs with the purpose of making a profit. The profit is made if the trader indicates the correct direction the currency pair is going to move in. Having said that, if the trader sells a currency pair, the expectations are that the market will move lower, and by the time they are closing the trade, the difference between the selling price and the closing price represents the profit. That is, the profit before expenses! The net profit results from deducting the commission and spread fees, as well as negative swaps, if there are any. When buying a currency pair, or when going long, the idea is to close the position from a higher level. The difference between the buying price and the closing one represents the profit before expenses. When reading the explanation about how to make a profit on the Forex market, everything seems straightforward. And it is! However, it is not simple. There are many factors that make currency pairs move aggressively on both sides, but most of the time the market is ranging. This means that upward moves are followed by strong moves in the opposite direction, and the other way around is possible as well. Ranges are the reality most of the time, and trends or impulsive move are not too frequent. Besides these factors that we’re going to mention here on the Trading Academy, there is one more thing that makes the whole market shift: the US dollar.

Why the US Dollar is King

Since the Bretton Woods agreement, the US dollar has been the world’s reserve currency. It is not known, or not clear to be more exact, whether this is a burden or a privilege for the US economy. This is because there are both advantages and disadvantages of a country’s own currency being the world’s reserve one. Nevertheless, because of that, everything is measured in dollars, even though recently there have been some signs that things are being put in place to avoid dollar payments, or to reduce the dollar’s influence.

* T&Cs apply to each of the offers. Click “Trade” for more details

The World’s Reserve Currency

us dollarAs the world’s reserve currency, the US dollar is the currency that is used to clear all deals around the world; or at least most of them. Oil is denominated in dollars, and every purchase or payment made by someone via their own bank from another currency is made only after a dollar conversion takes place. In this way there is one measured move for everything, and flows into the dollar happen both on the up- and the downstream. As mentioned earlier, it is not clear whether this is a burden or a privilege for the economy that has its currency as the world’s reserve one. For instance, imagine the role of the central bank, in this case, the Federal Reserve of the United States (Fed). Because the whole world is moving around the dollar, as this is how the financial system currently works, the interest rate on the dollar is key for the global economy, not only for the United States. The Fed therefore has to consider global factors as well as local ones when setting the interest rate for the dollar. Strictly from a mandate point of view, the Fed has a clear one: to keep inflation below or close to 2%, and to create jobs. However, because the dollar is the world’s reserve currency, the Fed cannot simply move rates based only on the mandate, as the mandate refers to the local economy, the US one. It is not surprising to hear the Fed talking about China’s economy, or about other factors around the world that have made the Federal Open Market Committee (FOMC) postpone an interest rate decision. In reality, this is the norm.

Connection with Emerging Markets

What happens with the US dollar is crucial for emerging markets’ economies. As a quick note, emerging markets are the ones that base their growth on heavy loans, and because of the US dollar’s status, those loans are in dollars. To understand why this matters, consider the situation after the 2008 financial crisis: The Fed slashed the rates to almost zero, and in the following 7 years embarked on an easing programme, the so-called quantitative easing. In turn, the dollar devalued against a basket of currencies, but something else happened: emerging markets could borrow in dollar terms at extremely cheap rates. However, the US economy is at a point now that the risk of inflation is high, and the economy is almost reaching full employment. This puts the Fed under pressure to hike rates. Those emerging economies that borrowed when the dollar was cheap would be forced to return the loans, paying more for the dollar.

Usually, emerging market economies are extremely volatile due to various local factors, and the fact that they must pay more because the interest rates in the United States are rising only adds to any uncertainty. As a result, the Fed has an extremely difficult role when setting the interest rate on the dollar, as in fact it is setting the interest rate for a currency that is used widely on a global scale. Nowadays what is happening with the US dollar is even more important for the global economy. As we all know, Mr. Trump has become the new US president, and under his leadership, there are expected to be a lot of changes. Only the fact that he was elected propped up the dollar. The idea behind a higher dollar comes from the fact that Trump promised to get rid of the 35% corporate tax that applies currently in the US on profits that are made outside the United States. If this is going to be changed, the US companies might be interested in bringing that hoard of cash back to the States and paying dividends to their shareholders, engaging in local expansion, and investing in research and development programmes, etc. This in turn will lead to a shortage of dollars around the world. Because of everything discussed here regarding emerging markets and the loans that exist, this shortage of dollars will pose an even higher risk for the world’s economies. Moreover, populist measures, and especially protectionist ones, carry a high inflationary premium, and this is something that concerns the Fed. In the end, the dollar is here to stay as the centerpiece of the world’s financial system, even though there are signs that in the future this may change. The recent acceptance of the Chinese yuan in the  Special Drawings Rights (SDR) of the International Monetary Fund (IMF), dilutes the role of the dollar, although rest assured it is here to stay for quite some time yet.

.

Recommended Further Readings

Other Educational Materials